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Bank of England Essay

The real reason why the flow of funds approach has been so attractive in the UK over the years is that the Bank of England has sought to control new lending by changing interest rates.

Introduction

The following paper analyses the Bank Of England’s approach to lending. It also aims to provide an in depth analysis of why the flow of funds approach has been successful in the UK. Prior to starting the discussion it is important to understand the flow of funds approach and how the Bank of England controls lending by changing the interest rates.

Flow of Funds Approach

The Flow of Funds approach is a very general approach which analyses the changes in the structure of the interest rates. The key assumption made in this approach is that the real interest rate is variable and is aligned with a given level of savings with investment needs. Secondly, it examines the broad determinants of savings in a macroeconomy. Thus according to this approach savings is represented as the source of funds and the domestic investment expenditure represents the use of those funds.

The model begins with the Income Identity:

Y = C + I + G + NX

rearranging terms:

Y - C - G - NX = I(r)

where the left-hand-side of the equation represent the source of funds and the right-hand-side, the use of funds. Additionally, we note that Investment decisions are (negatively) related to the real rate of interest ‘r’.

It is important to keep in mind that these funds being transferred from lender to borrower represent scarce resources. These resources are made available via the saver foregoing current consumption allowing these resources to be used for the creation, accumulation, and replacement of capital — capital that will allow labour to be more productive in the future.

It is generally recognised that flow of funds analysis is potentially of great importance because a main function of the flow of funds accounts is to reveal the sources and uses of funds that are needed for growth and development (Klein, 2000, p.ix).

As Green (1992) states that the flows of funds arise from the transactions which take place in an economy - whether involving purchases or sales of goods and services or exchanges of assets and liabilities. These transactions generate flows of funds from one agent to another and from one sector to another. National flow of funds accounts provides a record of these flows for the whole economy. All macroeconomic models call for the use of some part of the flow of funds. However, the expression "flow of funds models" refers specifically to modeling and understanding the flow of funds as a whole, and its role in interest rate determination.

Copeland (1952) is generally regarded as the pioneer of flow of funds analysis. He aimed to show all transactions in the economy - involving goods, services (including factor services), assets and liabilities, and distinguishing between purchases and sales in each category. Indeed, he originally conceived his work as an alternative to the national accounts. According to Dawson (1996) the flow of funds should be seen as one component of the whole national accounts system, rather than a whole or an alternative to national accounts.

However, the modern flow of funds accounts shows net transactions in financial instruments among broad sectors of the economy. They are typically presented in a matrix in which each row (i) represents an asset, and each column (j) a sector. Each cell (i,j) in the matrix shows net purchases (+) or sales (-) of asset i by sector j during the unit time period (usually a quarter or a year). The row sums of the matrix are zero as net purchases of an asset must equal net sales, and each column (j) sums to the j’th sector’s surplus or deficit - its Net Acquisition of Financial Assets (NAFA). Sector NAFAs can be calculated either by summing each sector’s transactions in assets and liabilities, or from the income side as the difference between gross investment (plus net capital transfers) and gross saving. They therefore provide the link between the flow of funds and national income accounts. Flows of funds are also related to the stocks of assets and liabilities in the economy through the identity that the change in the stock of an asset over any time period must be equal to the sum of the net transactions in the asset (i.e. the flow of funds) and capital gains or losses on existing holdings.

Bank of England and Lending

Bank of England’s key responsibility is to provide financial and monetary stability in the UK economy and it primarily achieves this aim by controlling the interest rate. Similar to the objective of any other central bank, Bank of England’s objective is also to safeguard the value of the currency in terms of what it will purchase. Rising prices - inflation - reduces the value of money. In order to meet this objective Bank of England uses the monetary policy instruments. In addition it also provides a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money - the interest rate. In May 1997 the Government gave the Bank independence to set monetary policy by deciding the level of interest rates to meet the Government’s inflation target - currently 2%.

Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy. Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can be damaging to the functioning of the economy. Low inflation can help to foster sustainable long-term economic growth.

Bank of England started its monetary reform in the early 1980s as a result of the debate on monetary base control (MBC) which was initiated by the first Thatcher government elected in 1979. Although the case for MBC was eventual rejected by the Government, the new money market arrangements were designed to leave open a move in that direction and anyway to loosen official control over rates and give the market more influence on rates within an unpublished band. Continuous posting of MLR was abandoned, as was the preannouncement of OMO dealing rates and the practice of deliberately creating a shortage by over issuing Treasury bills on Her Majesty Government’s behalf. It was also at this point that the Bank began to publish each day its estimate of the market shortage or surplus - relative to the clearing banks’ desired operational balances. The Bank aimed to broadly offset the cash flows between the Bank and the money markets so as to leave the clearing banks within reach of their desired balances. The aim was to do this primarily through OMOs and not through lending to the discount houses. Through the 1990s, the Bank did not analyse the instruments of monetary policy implementation very closely. The mid-1990s reforms achieved many useful improvements, but they did not include a review of the overall framework.

Thus in order to continue to keep control over the lending Bank of England will be introducing a new system of open market operations, whereby, the Bank’s short-term lending via open market operations (OMOs) will be conducted weekly rather than, as now, daily. The rationale behind the new system will be based on averaging of voluntary reserves alongside widely available standing deposit and lending facilities. It is believed that the new weekly OMOs will have a maturity of one week, so that the entire stock of short-term repo lending will roll over each week. In addition, the introduction of reserve accounts will increase significantly the amount of funds that the Bank needs to provide via OMOs. The purpose of the Bank’s operations in the sterling money markets is to implement the Monetary Policy Committee’s (MPC) interest-rate decisions while meeting the liquidity needs, and so contributing to the stability, of the banking system as a whole.

Conclusion

From the preceding paragraphs it can be concluded that the principal of flow of funds approach has helped the Bank of England to achieve its objective of maintaining financial stability and keeping inflation under control. In addition it has helped Bank of England to have better control over lending through interest rates.

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